Problem:
A large size company is considering to invest in a new project that costs
Tk.4,00,000. The estimated salvage value is zero; tax rate is 35%. The company
uses straight line depreciation and the proposed project has cash flows before
tax (CBFT) as below:
Year
|
Profit
before Tax and Depreciation
|
1st year
|
1,00,000
|
2nd year
|
1,00,000
|
3rd year
|
1,50,000
|
4th year
|
1,50,000
|
5th year
|
2,50,000
|
Required:
Determine the following: (i) Payback period; (ii) ARR; (iii) NPV at 15%; (iv)
Profitability Index.
(The PV at 15% are 0.870; 0.756; 0.658; 0.572;
0.497)
Solution:
Depreciation = Cost – Salvage value/No.
of year in lifetime = 4,00,000-0/5 = 80,000.
Statement
of cash inflow:
Particulars
|
1st
year
|
2nd
year
|
3rd
year
|
4th
year
|
5th
year
|
Profit before Tax & Depreciation
Less Depreciation
|
1,00,000
80,000
|
1,00,000
80,000
|
1,50,000
80,000
|
1,50,000
80,000
|
2,50,000
80,000
|
Profit before Tax
Less Tax @35%
|
20,000
7,000
|
20,000
7,000
|
70,000
24,500
|
70,000
24,500
|
1,70,000
59,500
|
Profit after Tax
Add depreciation
|
13,000
80,000
|
13,000
80,000
|
45,500
80,000
|
45,500
80,000
|
1,10,500
80,000
|
Cash inflow
|
93,000
|
93,000
|
1,25,500
|
1,25,500
|
1,90,500
|
Required
1: (Pay Back Period (PBP):
Year
|
Cash
inflow
|
Cumulative
cash inflow
|
1
|
93,000
|
93,000
|
2
|
93,000
|
1,86,000
|
3
|
1,25,500
|
3,11,500
|
4
|
1,25,500
|
4,37,000
|
5
|
1,90,500
|
6,27,500
|
PBP
= 3 + (Total investment – 3rd year cumulative cash inflow)/4th
year cash inflow
= 4 + (4,00,000 – 3,11,500)/1,25,500 = 3.71 years
Required
2: Average rate of return:
ARR= (Average annual profit / Average
investment)*100
=[{(13,000+13,000+45,500+45,500+1,10,500)/5}/(4,00,000)/2]*100=(45,500/2,00,000)*100
= 22.75%
Required
3: Net Present Value (NPV) calculation:
Year
|
Cash
flow
|
Discount
factor@10%
|
Present
value
|
1
|
93,000
|
0.870
|
80,910
|
2
|
93,000
|
0.756
|
70,308
|
3
|
1,25,500
|
0.658
|
82,579
|
4
|
1,25,500
|
0.572
|
71,786
|
5
|
1,90,500
|
0.497
|
94,679
|
Present Value of cash
Less, investment
|
=4,00,262
=(4,00,000)
|
||
Net Present Value (NPV)
|
262
|
Required 4: Calculation of Profitability
Index (PI)
PI = PV of cash inflow/PV
of investment cost
= 4,00,262/4,00,000 = 1.000655
Ans:
i)
Pay Back Period 3.71 years
ii)
ARR = 22.75%
iii)
NPV = 262
iv)
PI = 1.000655
Comments:
Out of 5 years project life, the investment will return within 3.71 years, ARR
is 22.75% which is higher than cost of capital, PI is greater than 1 and NPV
value negative, So the project is viable.
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